In the first part of this article, I explained the merits of the new debt-ceiling deal that the president and Congress reached in Washington last weekend. I also pointed to the limitations of the deal, in particular the apparent absence of any referral to the long-term threat that de-dollarization poses to the U.S. economy.
In this part, I am going to outline the broader framework of the de-dollarization process and the potentially catastrophic consequences. I want to make clear, though, that the scenario I am going to play out is by no means morally desirable—it is presented solely for the purpose of opening a dialogue about the rising threat to the current global economic and political order.
I finished Part I with a blunt question: “What if Russia wins in Ukraine?” This is a difficult question to entertain for obvious moral reasons; the world has seen too many wars already where the immoral aggressor has claimed victory. Nevertheless, as the European Union’s top diplomat recently explained, the outlook for Ukraine is not optimistic.
Before we explore the possible economic and political consequences of a Russian victory, let us first get back to de-dollarization. We understand this phenomenon to be a permanent reduction of the use of U.S. dollars as:
a) the reserve currency of central banks around the world, and
b) the currency in which international trade and financial transactions are denominated.
A decline in the dollar as a reserve currency leads to a decline in its use in trade. The reason is simple. Suppose exporters in Country A demand from their buyers in Country B to get paid in A currency. Importers in Country B then have to buy A currency for their B currency, so they can pay the people from whom they buy goods and services. This arrangement means that the central bank in Country B will start holding A currency in its currency reserve, and do so in such volumes that importers can always get the currency exchanged expeditiously.
Suppose that the central bank in Country B one day declares that it is going to hold large amounts of Country C’s currency in its reserve. Businesses in Country B that denominate their international trade contracts in C currency will get expedited treatment when it comes time to exchange export revenue into domestic currency.
In order to maintain that expedited status, i.e., to not have to wait to get foreign revenue exchanged for domestic currency, more and more firms participating in trade between Countries A and B will make sure to have C currency available.
In other words, they will follow the lead of their central bank and start using the currency that the central bank has decided to hold in its currency reserve.
Somewhat stylistically, this is how de-dollarization would spread from central bank portfolios to international trade. This is also how de-dollarization would progress if the current efforts in that direction gained enough momentum.
It is worth noting that de-dollarization as described here, i.e., being driven by leaders of other nations whose political ambitions motivate them to ‘take down’ the dollar, is not the only form of de-dollarization. It can also happen organically, simply because the global economy evolves and diversifies. In fact, the world has been slowly moving away from the dollar since at least the late 1990s, and the reason is just that: it has simply become more natural for central banks to increase their holdings of new currencies, and by default reduce their dollar balances.
In the past 25 years, the dollar share of so-called allocated central bank currency reserves has fallen from almost 75% to less than 60%. Figure 1 reports that share, together with a trend line suggesting that in the next few years, the dollar could account for less than half of those reserves:
Figure 1
Source of raw data: International Monetary Fund
It is important to note that the solid line is not a formal forecast; there is nothing deterministic or even probabilistic about it. It is only a mathematical extrapolation of a trend in recent history. The events that brought the dollar share down as described here, namely the growth of global trade in general, and the integration of China and other major, formerly developing economies, have motivated central banks to make changes to their currency reserves. Those events and trends may not have the same influence on the dollar in the coming years.
The currencies that have emerged in recent years are not what one would expect: Australian and Canadian dollars. So far, China has not made any significant footprint in central bank reserves, at least not on a global scale. (The reserve portfolios of individual central banks are considered confidential and are therefore not available in statistically comparable formats.) At the end of 2022, the renminbi accounted for only 2.7% of the foreign currencies that the world’s monetary institutions had in their portfolios. The Japanese yen was twice as important.
At 20.5%, the euro was the world’s second most important reserve currency.
It is easy to get the impression from these numbers that the dollar would have to fall far and deep in terms of its currency-reserve status before it has any significant impact on the dollar itself. That is not true: a deliberate process by a group of countries to reduce the status of the dollar could have its intended effects much sooner than that. As I mentioned in an earlier review of de-dollarization, it only takes China, India, Brazil, and a small number of other countries to release enough dollars to—at least in theory—cause double-digit inflation in America.
In addition, political psychology will probably play a more important role than the hard realities of monetary policy and finance.
Figure 2 suggests a scenario where the politically motivated efforts at reducing the dollar’s global status bear fruit. The trajectory itself is purely illustrative; the big question is how the American president and Congress will react when the reserve share of the dollar falls at a pace that becomes statistically meaningful over the short term.
Figure 2
Source of raw data: International Monetary Fund
In this accelerated de-dollarization scenario, the U.S. currency would weaken vs. other major currencies at a pace that is certain to attract public attention. It would also trigger an effort from the Federal Reserve to counter the decline; the extent to which the dollar depreciates depends on the force by which the central bank can intervene and the strength of U.S. financial markets.
Market strength may turn out to be the key factor: it decides whether or not there will be a flight of investors who already hold stocks in American corporations, Treasury securities, and other assets denominated in U.S. dollars. If they are undisturbed by the depreciation of the dollar, they will keep their assets and weather the storm, so to speak.
We can hope for this scenario, and there are some reasons to believe it will play out. International investors take exchange-rate fluctuations into account when they make their portfolio decisions. They include measures to handle such fluctuations in their investment strategies, and they are usually successful at mitigating the ups and downs in the currency markets.
That said, there is always a limit to what an investor can do in terms of hedging against risk and, in particular, uncertainty. A structural weakening of the global status of the dollar is not within the realm of what investors can usually insure themselves against. For this reason, there is a risk—a likelihood in fact—that investors would grow uneasy with a sustained, rather visible downward pressure on the dollar. If their worry about the currency grows strong enough, they will set in motion a flight of foreign investors out of American markets.
This would not only exacerbate the weakening of the dollar but also cause dangerous asset-value deflation across multiple markets in the U.S. economy.
There is only one institution that can cool down investor sentiments at this point, namely the Federal Reserve. They would have to work overtime to reverse the de facto rise in the money supply that the de-dollarization causes. This is more difficult for a central bank than it is to print money; it takes considerable muscle in the form of assets that the central bank can sell, and thus rake in cash.
As far as the Federal Reserve is concerned, those assets consist of $5 trillion worth of U.S. Treasury securities. This is the domestic sovereign-debt portfolio that the Federal Reserve owned at the end of 2022. If it sold it off successfully, i.e., without any capital losses, it would make a significant impact on the U.S. money supply. However, in order to make it happen the Fed would need to team up with large, institutional investors. They would have to purchase those assets at exceptional levels.
If they do, international investors may perceive the Fed as ‘credible enough’ in its efforts to stabilize the currency. The result could be that the flight from the dollar comes to an end.
Unfortunately, unlike its money-printing endeavors, the Federal Reserve does not have endless muscle in terms of reducing the money supply. The big question is if its efforts to ‘vacuum’ the international currency markets for dollars can keep up with the size and the pace of the currency-reserve drawdown.
If that pace picks up beyond the ability of the Federal Reserve, then the dollar is in real trouble.
One event that could upset the U.S. central bank’s efforts at staving off de-dollarization, is a Russian victory in Ukraine. As utterly undesirable as this scenario is, we nevertheless need to consider it.
Let us define the victory as the Russians would see it, namely that they have full control over Ukraine’s status vs. NATO, the EU, and other international organizations.
A Russia with this kind of victory under its belt would emerge from the war in a very different global position than that which it had before the invasion. They would use this considerably stronger position in part as de-dollarization leverage. Conceivably, they would reach out to Europe in order to reopen relations; it would be rash to assume that Europe, demoralized by a Ukrainian loss and plagued by a recession, would ignore the Russian invite.
To make this scenario even more troubling from a U.S. perspective, suppose the Russians offer Europe their natural resources at good deals and invite European businesses to help rebuild Ukraine.
Would Europe say no? Morally speaking, the right answer would of course be just that. However, with Europe in a recession, and with the United States weakened by an aggressive de-dollarization effort and by a Ukrainian loss, the response to Moscow may not at all be moral in nature. It may be cynically economic.
At this point, the geopolitical changes in Europe will take on proportions that we have not seen in many decades. It could begin to resemble the aftermath of World War II. Influence from an emboldened Russia, intent on reducing the importance of the dollar, could at least in part bring Europe along.
It is not worth speculating in any detail how such a scenario would unfold; the realm of uncertainty in it is far greater than what such speculation could manage. However, it is also not necessary to bring this scenario any further; the point is that this scenario is no longer unthinkable. Given its consequences, the real question to ask is what steps can be taken by the United States and whoever else is interested in preserving the U.S. dollar as the global reserve currency.
In plain English: can the U.S. government and its allies prevent a determined group of countries from making themselves independent of the dollar, and significantly hurting the U.S. economy in the process?
